Warning as UK heads for deflation

Politicians and analysts have warned that Britain is on the verge of deflation after economic data released this morning showed that living costs are rising at their lowest rate in almost 50 years.

Figures from the Office for National Statistics showed that the retail prices index, which includes mortgage costs, fell to just 0.1% in January following the recent falls in interest rates and cheaper fuel. This is the lowest RPI level since March 1960, and it is expected to enter negative territory soon.

Liberal Democrat Treasury spokesman Vince Cable said inflation was now "virtually disappearing" as a threat to families, although this might not be obvious to those facing higher council tax bills.

"It is becoming clear that for the foreseeable future there is a higher risk of deflation than inflation, which is why it is inevitable and sensible that the Bank of England should be moving towards expansion of credit and the money supply directly," said Cable.

RPI is the measure typically used to determine pension changes and wage rises, so many people suffer when it falls.

George Buckley, analyst at ­Deutsche Bank, predicted that falling house prices and lower mortgage interest payments would ensure that RPI soon turns negative.

The Bank of England, though, is charged with controlling inflation measured on the consumer prices index (CPI). That also fell in January, but by less than expected.

CPI dropped to an annual rate of 3% in January from 3.1% in December. Fuel prices plunged by 15.2%, the biggest fall on record.

The City had expected CPI to fall further to 2.7%, but the cost of games, toys and furniture held steady in January following heavy discounting in the run-up to Christmas. The collapse of Woolworths and furniture chain MFI helped to spur retailers to slash their prices in December, meaning the traditionally post-Christmas sales period started earlier than ever, and retailers were therefore reluctant to lower prices even further in January.

The pound strengthened against the dollar to $1.4270 on the news, from $1.4146 just before the figures were released.

Economists expect CPI to drop sharply in coming months amid sliding commodity prices and a slowing economy, piling pressure on the Bank of England to take further action to stimulate the economy.

The Bank has slashed interest rates to a record low of 1% and is now considering more drastic measures to get consumers and businesses spending again.

Bank governor Mervyn King said last week the monetary policy committee would discuss "quantitative easing" – boosting the flow of money in the economy – when it meets to decide on interest rates next month.

Today's inflation number "is not going to change what the MPC is going to do next month, which is quantitative easing and cutting interest rates", said Brian Hilliard, chief UK economist at Société Générale. "The MPC knows prices are coming down. One thing that has not had a big impact, but will, is utility prices. It will have a big influence on inflation."

The Bank expects CPI to drop as low as 0.5% this year and to remain well below its 2% target until 2012, even if interest rates are cut further.

Analysts warned, though, that the fall in the value of the pound has pushed up the prices of some imports, such as food.

And the Alliance Trust research centre said today that pensioners face inflation of over 5%. It warned that recent hikes in gas and electricity prices and food price inflation have hit the elderly the hardest during the winter months.

"This high level of inflation facing the elderly is particularly worrying during these cold winter months as the need to pay elevated gas, electricity and food prices leaves elderly households with much less money to spend elsewhere," said Shona Dobbie, head of the Alliance Trust Research Centre.

Younger people, who spend more of their income on audio visual products, clothing and footwear, are experiencing lower inflation, Dobbie argued.

"The current gap between the inflation rates facing the young and elderly remains wide and is of great concern at a time when older people who rely on income from savings may also be suffering from the effects of falling interest rates," she added.